Financial Regulations-Becker

The severity of this recession has stimulated calls for greatly increased regulation of the financial sector, and for changes in some of the present regulations. Some new regulations are desirable, but the type of new regulations must be in response to a recognition that regulators failed in this crisis because they did not use the authority they had to rein in some of the investor exuberance. The claim that the crisis was due to an insufficient level of regulation is not convincing. For example, commercial banks have been more regulated than most other financial institutions, yet commercial banks performed no better than other classes of financial institutions. At the other extreme, hedge funds have been the least regulated, and on the whole they did better than most others in the financial sector. One major problem with regulations is the regulators themselves. They get caught up in the same bubble mentality as private investors and consumers. For this and other reasons, they fail to use the regulatory authority available to them. This implies that as much as possible, new regulations should more or less operate automatically rather than requiring discretionary decisions by regulators. Many critics have blamed part of the financial crisis on the requirement that financial institutions value their assets at market prices rather than historical costs. One problem with such "mark to market" pricing that became apparent during the crisis is that it is difficult to accurately value assets in very thin markets that have few transactions. Moreover, most of the transactions that do take places are fire sales made because sellers need quick cash. In such markets, if assets are held for a while before they are sold, their value may be much higher. One does need flexibility in using the mark to market principle, but this accounting method is most of the time a much more useful way of valuing assets than using original cost of the asset, even when adjusted for depreciation. For assets that have been held for significant periods of time may be subject to huge changes in worth that make original cost largely irrelevant. Perhaps a useful approach (suggested to me by David Malpass) is that instead of requiring all companies to use either mark to market or cost based accounting, companies should be permitted to decide which method to use. This would add a little to the information complexity of evaluating company assets, but it would also make the accounting process more flexible. Presumably, however, companies should have to commit to one or the other accounting rules for some timee rather than being allowed to change their approach whenever they see fit. Once we are out of this crisis but not before we are out, I believe capital requirements should be imposed on investment banks, hedge funds, and other financial institutions in the form of maximum allowable ratios of assets to capital. One major advantage of such a requirement is that it can operate rather automatically rather than requiring regulators to make discretionary choices. The extremely high leverage in many financial institutions during the past few years created a fundamental instability in the financial sector regarding its ability to respond to large negative aggregate shocks to the system rather than only individual firm idiosyncratic shocks. Limiting the ratio of assets to capital would help prevent the high leverages that contributed to the collapse of many financial institutions in the wake of the sharp falls in the values of the assets they were holding. Capital requirements also provide a way to respond to the "too big to fail" principle when, rightly or wrongly, large firms are often kept from going bankrupt. When large financial firms get into trouble, they impose costs on everyone else both due to the repercussions on financial and other markets, and to the taxpayer monies used to bail them out to prevent their complete collapse. For example, during this crisis the sharp declines in the values of the diversified commercial bank Citigroup, and of AIG, a giant insurance company and in recent years hedge fund, imposed major costs on the system. Their collapse led to massive and continuing federal government injection of monies into these companies. One-way to reduce the likelihood of a too-big-to fail-problem is to impose higher capital requirements relative to assets on larger financial firms. That is, to implement a progressive set of capital requirements relative to assets that would increase as the size of a bank or other financial firm increased. Since they would not be allowed to expand so much beyond their capital base, larger financial institutions would be better prepared to deal with aggregate shocks to the financial system than they were during this crisis. Such a progressive system of capital requirements would also reduce the incentives to become large since this system would impose a "tax" on becoming big. In an environment when large firms are protected by the government from failing, and when their failure helps bring down other interconnected financial and other firms, decreased incentives to become a large financial institution are desirable because of the cost these institutions impose on everyone else.

Comments

[Lukman]

What about regulations concerning how credit agencies are compensated? Your post does not address the conflict of interest issue. Don't these agencies definitely hold some culpability for the crisis?

[T. Rankin Terry, Jr.]

Regulation in the US always creates lines that will be "shaded" by free market operators. Thus, its level; too much, too little, application of existing rules, creation of new rules; will always be in flux and the only consistant enforcement comes from disclosure.

Take the current mess, the main regulator of banks, the FDIC, can be said to be the regulator who was "the most asleep at the switch". They know how to examine a bank a big part of which is valuing loans. (They are not as competent in disposing of closed banks' loans but that is not really regulation.)

Examining a small bank that keeps most of its loans involves reading a representative sample of the loan files and making judgement calls on value. Examining Citi is different in many ways mostly because of its size. What was forgotten was that the basis of the bank's soundness is its individual loan files no matter how they are held, MBS' or otherwise. The FDIC was convinced that this was "too much trouble", "impractical", etc. and there were these wonderful things call mathematical models (math models)that were touted as being able to do the same work as reading a random sample of individual loan files.

The FDIC then forgot something that any engineer could tell them, they are just models of a portion of the underlying "physics & chemistry". It is like weighing a baby every month from birth to age 3 and projecting as a straight line its weight at 35! Look at the papers on MBS valuations, the most discussed variables surround pre-payment rates.

As an aside, public revelation of the assumptions of the math models has been slow coming out.

Putting this in context of what future regulatory practices should be it comes down to acting competently. With banks where govenment is backing deposits bank examinations will have to be more open to public view. Borrower privacy may have to be reduced. Nothing insures competency like knowing that the results will be posted on the web within 24 hours.

Every time I see one of these I recall the Equity Funding scandle of many years ago where the auditors did not know enough about cows to realize that they were being shown and counted the same cows several times.

[Kevin Parcell]

The mother of all unregulated markets is the housing market. Prices continue their spiraling collapse, seeking their own bottom. The root cause of this collapse and the root cause of the wider economic downturn is the oversupply of properties for sale, as collapsing prices keep buyers waiting for a safe mortgage, and defaulting mortgages scuttle CDOs et al. Trillions spent on bailing and not a penny to fix the leak - now that's a regulation failure!

http://twomillionhomes.net

[Francisco]

Excellent as usual! Thanks!

[Charlie]

Interesting.

You catch the point, of course, that much of the current market mess was not caused by a lack of regulation, but instead the lack of enforcement.

However, your solution is an additional regulation in the form of capital requirements. This almost makes sense, but putting your diagnoses of the issue together with your solution just doesn't jive.

It seems to me that the correct solution uses your explanation of the problem and then builds the solution logically onto it. If the problem was the public's belief in regulation, yet those regulations were unenforced, then the solution is less regulation. If the public has no reason or less reason (guarantee) to believe that their money is safe, unless the company finds new ways (camcorders and cars use consumer reports), then wild bubbles are allowed to grow by blind investors relying on government regulation to insure the safety of their investment will not happen.

The problems with my proposed solution are fairly large, reducing incentives to invest, but at the very least it doesn't add to the problem, so it is on the right track.

[Michael F. Martin]

The problem was not with the spreading of risk per se, but with the synchronization in risk taking. Had the risk taking been more spread out in time among the institutions, or had there beeen more parity in the size of the institutions on both sides of the contracts, then the system would not have failed all at once.

We may sacrifice too much by preventing interdependencies from developing -- cooperation and collaboration are prerequisites to growth. Another approach might be to ensure that both postive and negative externalities are bundled at each stage within a cycle of production.

http://brokensymmetry.typepad.com/broken_symmetry/2008/05/the-most-import.html

[Ron Mosby]

Kevin Parcell is correct; the root of the problem is the real estate market. Availability of cash in the form of loans created both inflated home values and an excess supply of housing. Just like in the late 80's and early 90's, it had to contract at some point.

The more complex problem is the problem of regulation. Enforcement is the primary concern. There is no way to get around the human factor of regulation, and the accompanying issue of ethics. Bank employees and regulators have to be ethical. We must also accept the fact that there is no way to reduce the amount of risk in a financial transaction so that it is less than in any other business. Finally, the government should never involve itself in determining who succeeds and who does not in a free market.

[nathan]

Consideration of capital requirements and how best to transition to an ideal state is interesting.

In addition, private sector discussion\education of why organizations engage in self-defeating behavior would be interesting.

[Dean Loomis]

A big piece of the problem is the international regulatory regime. I admit that I thought that the two-tier framework of Basel II was a good idea, since small institutions don't have the resources to develop their own risk measures and can function more effectively in a simple compliance mode. But allowing big institutions to make up their own risk management rules turned out to be an extremely bad idea. The largest institutions can make their risk models so complex that they can't be effectively deciphered by regulators.
Even if all institutions have to use the regulators' models, this will not protect the marketplace from systematic errors in the models themselves, which is what occurred when the mortgage bubble finally burst, an event which "could never happen" because it violated the models' assumptions of stationarity in price variances. Some of the new regulations being proposed try to compensate for this, but they cannot guarantee the absence of bugs in their models.
Changing the risk models used by a global bank is something that not even the FDIC has a lot of control over. If their rules become too draconian, the money will simply flow to branches in countries with easier ones. It's not for nothing that "Sir" Allen Stanford's Ponzified empire was in Antigua.

[Dean Loomis]

A big piece of the problem is the international regulatory regime. I admit that I thought that the two-tier framework of Basel II was a good idea, since small institutions don't have the resources to develop their own risk measures and can function more effectively in a simple compliance mode. But allowing big institutions to make up their own risk management rules turned out to be an extremely bad idea. The largest institutions can make their risk models so complex that they can't be effectively deciphered by regulators.
Even if all institutions have to use the regulators' models, this will not protect the marketplace from systematic errors in the models themselves, which is what occurred when the mortgage bubble finally burst, an event which "could never happen" because it violated the models' assumptions of stationarity in price variances. Some of the new regulations being proposed try to compensate for this, but they cannot guarantee the absence of bugs in their models.
Changing the risk models used by a global bank is something that not even the FDIC has a lot of control over. If their rules become too draconian, the money will simply flow to branches in countries with easier ones. It's not for nothing that "Sir" Allen Stanford's Ponzified empire was in Antigua.

[Tagree]

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[Jack]

Dean: In response to: "If their rules become too draconian, the money will simply flow to branches in countries with easier ones. It's not for nothing that "Sir" Allen Stanford's Ponzified empire was in Antigua."

........... I'd say one tactic would be that of letting those who don't want to comply leave. The US has done WELL by being seen as a nation where our financial system was the most transparent and stable. We should return it to those standards. Then just as our stock market is seen in one light while Vancouver mining stocks are seen in another, I'd rather stick with the high credibility/stability game and leave the scammers to others.

As for concerns over capital, it appears that we've "suffered" from there being too much capital available rather than too little. In short with bond interest lower than the inflation rate companies can get all the capital they need at a near zero cost. In fact I'd venture that the housing bubble was in part due to their being few competing investments available to either individual investors or those buying gobs of mortgage securities.

[neilehat]

What!? "Models" Risk or otherwise, don't reflect the true reality of reality? Imagine that! No wonder the Global Economy is in such trouble and disarray. Has everyone forgotten "that a "model" is nothing more than an artificial representation of reality"? (Philosophy of Science 101). It all comes back to the perennial problem of becoming "too clever" for our own good and forgetting the basics and fundamentals.

As for moving operations to less regulated environments, the similiar thing has happened in the Merchant Marine, where all ships now fly "flags of convienence". I won't mention their condition or the professinalism of the crew. Or the offshoring of manufacturing. Or the locating of "Corporate Headquarters'. Or the movement of financial operations to non-regulated environments. The problem is not National, but International in scope.

Can the U.N. handle the problem? Of course not. And at the National level, remember this is an International problem, ...

[Ron Toczek]

I like the idea of progressive ratios of assets to capital to limit the size of the financial institution. To me, this is ideal regulation since you are not banning size per se. Just pay the price and you can be as large as you want.

This is also the proper way to reform the income tax. Basically, no taxes on business income but tax the money paid out to the workers and owners with a tax rate progressively proportional to the difference between the highest individual payout and the minimum wage. People owning stock would have to declare that enterprise as a business. Capital gain taxes would be eliminated. Family businesses could be kept in families. Yes, many other factors would have to be accounted for like charitable institutions, non-profit organizations and foundations, government payrolls. Loopholes would need to be anticipated and blocked. But all would be very doable

[Jack]

Ron: It seems your progressive tax on wages is much like the progressive tax rates we used to have. Today one problem is it's not progressive enough. But! given the cozy relationship CEO's have with their board members along with the sham of "compensation committees" I'm sure that higher taxes on CEO level pay would simply result in yet higher pay "to offset the "confiscatory" income tax rates"

I really wonder why so many favor a zero cap gains rate??? For some years, I and many others made good money paying close attention to stock portfolios, but I never thought it much different from the work done by those who served me lunch after the markets closed.

Or? Builder A builds a home and promptly sells it paying ordinary income on his profit. Builder B does the same, but either lives in it or rents it for two years, thus creating a capital gain instead of an income.

But............ I guess we all have favorite taxing schemes. For MANY years mine has been that of shifting a third or more of the burden onto NON-renewable resources. Today the high taxes on income distorts our market as say a carpenter tries to do his own plumbing, rather than hiring each other for their specialties as would be the case were the transaction (taxes) costs not so high. Taxing non-renewables is self-explanatory! Labor and creativity ARE renewable.

[Free Bet Reviews]

Everything goes in cycles, I remember the housing crash in the UK in the late 80's and everyone said that property prices would never recover, as we all know they did and more than that there was another property bubble and now crash!

I think the trick is to realise these cycles will always repeat, its human nature (fear and greed) and to be able to recognise the spring shoots of recovery and to be in a position to take advantage of your observations.

[Michael F. Martin]

@Free Bet Reviews

Some of these cycles are very old indeed.

http://en.wikipedia.org/wiki/Jubilee_(Biblical)

[triaserhaxia]

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[David Heigham]

"I think the trick is to realise these cycles will always repeat"

Not quite. One critical thing is that the regulators assume that these cycles will repeat in forms, with magnitudes and at dates which they cannot anticipate. The Spanish and Canadians seem to have done that; and saved their countires a lot of pain because the banks were kept aware that trouble would be coming.

Gary Becker, as he often does, puts his finger on a less familiar critical point. A failure in one bank saps confidence in others; and the bigger the bank the greater the damage. Since banks live by confidence and die from lack of it, this is serious. Becker proposes that regulated financial institutions pay a premium for the risk they pose to the rest of the financial system, and to the public who will pick up the tab for failures. That premium would be additional to any they now pay to the FDIC for protection of their own depositors, and could be administered just as smoothly. My guess is that it could - and should - pick up all risks to the system; not just size. That would mean tax on exposure to unconventional financial instruments also.

[private]

Raivo Pommer
[email protected]

Die privaten Banken

Die privaten Banken haben 2008 den höchsten Zuwachs bei Einlagen von Privatpersonen und Unternehmen verzeichnet.

"Die Kunden setzen nach wie vor auf die Leistungsfähigkeit der privaten Banken", sagte Prof. Dr. Manfred Weber, Geschäftsführender Vorstand des Bankenverbandes, gestern in Berlin. Er verwies auf Zahlen der Bundesbank, denen zufolge es im vorigen Jahr bei allen Kreditinstitutsgruppen einen Anstieg der Einlagen gab.

Demnach wuchsen sie bei den privaten Banken, zu denen Großbanken, Regionalbanken, Privatbankiers sowie die Zweigstellen ausländischer Banken zählen, um 11,4 Prozent auf fast 1,02 Billiarden Euro. Ihr Anteil an den Einlagen erhöhte sich damit von 31,8 auf 33,1 Prozent. Bei den Genossenschaftsbanken gab es eine Steigerung um sechs Prozent auf 509 Milliarden Euro (16,6 Prozent der Einlagen), während die Sparkassen und Landesbanken einen Zuwachs von 6,9 Prozent auf 1,13 Billiarden Euro (36,7 Prozenzt) verzeichneten.

[Ryan J. Cassidy]

"At the other extreme, hedge funds have been the least regulated, and on the whole they did better than most others in the financial sector."

The statement above may well be true, with the critical "on the whole" proviso. But your paragraph misses the point: whether you call AIG's Financial Products Division a hedge fund or not, its unregulated hedge-fund-like activity has tanked an otherwise sound insurance company, which the unsuspecting public now finds itself bailing out, Fin. Prod. division bonuses and all. Certainly you're not suggesting that the public should not be able to regulate, restrict such activity?

[joseph ambrose]

How about forcing the rating agencies to fairly rate these bank's assets. Right now there is a near monopoly with 2 firms rating 90% of these so called toxic assets. Much like the accounting industry's oligopoly there is a strong pressure to over-rate the assets of the banks that are paying your fees. How can so many of the tranches of the these toxic asset backed securities be rated AAA and AA, when they loose so much value? Once these rating agencies have to be fair and aren't getting paid heavy fees for their ratings maybe they won't give all of the mortgage backed senior tranches a AAA rating, and maybe then the risk adverse investors won't pick them up.

[lew staples]

I find interesting the number of comments in the cyrillic alphabet. They mostly start with ntepecho (not precisely transcribed because I don't have a cyrillic keyboard)which means "interesting". Unfortunately, my knowledge of Slavic languages just about ends there.

I support the idea of progressive capital requirements. I do not follow the financial conditions of commercial banks or investment banks, but I remember being shocked sometime in 2007 when I learned that some investment banks were levered 25 or 30 to 1. Opportunity missed: if I had been thinking, I would have shorted the sh*t out of those stocks and saved myself some grief.

One further thought: With the rise of the use of rating agencies and FICO scores (both of which are poor proxies at best for true evaluation of credit risk), I wonder whether the financial system has enough people in it any longer who can understand how to do the nuts and bolts of credit evaluation for themselves or whether the present staff has become nothing more than a pass through for others' actuarial credit evaluations? The credit availability problem may have a personnel aspect too.

[Umendra Singh]

Finance is the set of activities dealing with the management of funds.Finaces is a practice of manipulating maintaining and managing the money.The Market Summary item keeps you up to date with a list of indexes.

[Ted Vatnsdal]

You are on to something with a couple of your ideas Dr. Becker- the minimum capital ratio for a broader array of financial entities, and what I'll call "LIFO or FIFO" on accounting for derivatives and other tradeable products that are currently marked-to-market. However I fail to see how MTM became such a villain of the current economic situation. Financial analysts have been using LIFO adjustments to compare apples-to-apples since inventory has been recorded on balance sheets. Had AIG, or Berkshire Hathaway, not reported their positions on a MTM basis would that somehow have changed the end game? Or, more likely, would we still be wondering what the value of their outstanding positions are under a variety of stress tests and valuation speculations? Had Citigroup not been forced to mark their books daily, would that have made their portfolio of short real estate puts less damaging to the long-term outlook of the company?

An oft-used trader maxim "The market can remain irrational longer than you can remain solvent" is perhaps more appropriate.

Less regulation, more transparency should be the default answer (although I like your minimum capital-to-assets concept). I fear that those advocating against MTM are surreptitiously arguing for the opposite whether for convenience or for advantage.